Module 2

Fund Based Financial Services

Lease Financing
Meaning of leasing
Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must
pay a series of contractual, periodic, tax deductible payments. The lessee is the receiver of the
services or the assets under the lease contract and the lessor is the owner of the assets. The
relationship between the tenant and the landlord is called a tenancy, and can be for a fixed or an
indefinite period of time (called the term of the lease). The consideration for the lease is called
rent.

Lease can be defined as the following ways:

1. A contract by which one party (lessor) gives to another (lessee) the use and possession of
equipment for a specified time and for fixed payments.
2. The document in which this contract is written.
3. A great way companies can conserve capital.
4. An easy way vendors can increase sales.
A lease transaction is a commercial arrangement whereby an equipment owner or Manufacturer
conveys to the equipment user the right to use the equipment in return for a rental. In other
words, lease is a contract between the owner of an asset (the lessor) and its user (the lessee) for
the right to use the asset during a specified period in return for a mutually agreed periodic
payment (the lease rentals). The important feature of a lease contract is separation of the
ownership of the asset from its usage.

Importance of Lease Financing

Lease financing is based on the observation made by Donald B. Grant: ―Why own a cow when
the milk is so cheap? All you really need is milk and not the cow.‖

Leasing industry plays an important role in the economic development of a country by providing
money incentives to lessee. The lessee does not have to pay the cost of asset at the time of
signing the contract of leases. Leasing contracts are more flexible so lessees can structure the
leasing contracts according to their needs for finance. The lessee can also pass on the risk of
obsolescence to the lessor by acquiring those appliances, which have high technological
obsolescence. Today, most of us are familiar with leases of houses, apartments, offices, etc.

The advantages of leasing include:

a. Leasing helps to possess and use a new piece of machinery or equipment without huge
investment. .
b. Leasing enables businesses to preserve precious cash reserves.
c. The smaller, regular payments required by a lease agreement enable businesses with limited
capital to manage their cash flow more effectively and adapt quickly to changing economic
conditions.
d. Leasing also allows businesses to upgrade assets more frequently ensuring they have the latest
equipment without having to make further capital outlays.
e. It offers the flexibility of the repayment period being matched to the useful life of the
equipment.
f. It gives businesses certainty because asset finance agreements cannot be cancelled by the
lenders and repayments are generally fixed.
g. However, they can also be structured to include additional benefits such as servicing of
equipment or variable monthly payments depending on a business‘s needs.
h. It is easy to access because it is secured – largely or entirely – on the asset being financed,
rather than on other personal or business assets.
i. The rental, which sometimes exceeds the purchase price of the asset, can be paid from revenue
generated by its use, directly impacting the lessee's liquidity.
j. Lease installments are exclusively material costs.
k. Using the purchase option, the lessee can acquire the leased asset at a lower price, as they pay
the residual or non-depreciated value of the asset.
l. For the national economy, this way of financing allows access to state-of-the-art technology
otherwise unavailable, due to high prices, and often impossible to acquire by loan arrangements.
Limitation of leasing

a. It is not a suitable mode of project financing because rental is payable soon after entering into
lease agreement while new project generate cash only after long gestation period.
b. Certain tax benefits/ incentives/subsidies etc. may not be available to leased equipments.
c. The value of real assets (land and building) may increase during lease period. In this case
lessee may lose potential capital gain.
d. The cost of financing is generally higher than that of debt financing.
e. A manufacturer (lessee) who want to discontinue business need to pay huge penalty to lessor
for pre-closing lease agreement
f. There is no exclusive law for regulating leasing transaction.
g. In undeveloped legal systems, lease arrangements can result in inequality between the parties
due to the lessor's economic dominance, which may lead to the lessee signing an unfavorable
contract.
Types of Lease

1) Financial lease

Long-term, non-cancellable lease contracts are known as financial leases. The essential point of
financial lease agreement is that it contains a condition whereby the lessor agrees to transfer the
title for the asset at the end of the lease period at a nominal cost. At lease it must give an option
to the lessee to purchase the asset he has used at the expiry of the lease. Under this lease the
lessor recovers 90% of the fair value of the asset as lease rentals and the lease period is 75% of
the economic life of the asset. The lease agreement is irrevocable. Practically all the risks
incidental to the asset ownership and all the benefits arising there from are transferred to the
lessee who bears the cost of maintenance, insurance and repairs. Only title deeds remain with the
lessor. Financial lease is also known as 'capital lease‗. In India, financial leases are very popular
with high-cost and high technology equipment.

2) Operational lease

An operating lease stands in contrast to the financial lease in almost all aspects. This lease
agreement gives to the lessee only a limited right to use the asset. The lessor is responsible for
the upkeep and maintenance of the asset. The lessee is not given any uplift to purchase the asset
at the end of the lease period. Normally the lease is for a short period and even otherwise is
revocable at a short notice. Mines, Computers hardware, trucks and automobiles are found
suitable for operating lease because the rate of obsolescence is very high in this kind of assets.

3) Sale and lease back

It is a sub-part of finance lease. Under this, the owner of an asset sells the asset to a party (the
buyer), who in turn leases back the same asset to the owner in consideration of lease rentals.
However, under this arrangement, the assets are not physically exchanged but it all happens in
records only. This is nothing but a paper transaction. Sale and lease back transaction is suitable
for those assets, which are not subjected depreciation but appreciation, say land. The advantage
of this method is that the lessee can satisfy himself completely regarding the quality of the asset
and after possession of the asset convert the sale into a lease arrangement.

4) Leveraged leasing

Under leveraged leasing arrangement, a third party is involved beside lessor and lessee. The
lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender
and the asset so purchased is held as security against the loan. The lender is paid off from the
lease rentals directly by the lessee and the surplus after meeting the claims of the lender goes to
the lessor. The lessor, the owner of the asset is entitled to depreciation allowance associated with
the asset.

5) Direct leasing

Under direct leasing, a firm acquires the right to use an asset from the manufacture directly. The
ownership of the asset leased out remains with the manufacturer itself. The major types of direct
lessor include manufacturers, finance companies, independent lease companies, special purpose
leasing companies etc
Other types of leasing:

1) First Amendment Lease: The first amendment lease gives the lessee a purchase option at one
or more defined points with a requirement that the lessee renew or continue the lease if the
purchase option is not exercised. The option price is usually either a fixed price intended to
approximate fair market value or is defined as fair market value determined by lessee appraisal
and subject to a floor to insure that the lessor's residual position will be covered if the purchase
option is exercised.

2) Full Payout Lease: A lease in which the lessor recovers, through the lease payments, all costs
incurred in the lease plus an acceptable rate of return, without any reliance upon the leased
equipment's future residual value.

3) Guideline Lease: A lease written under criteria established by the IRS to determine the
availability of tax benefits to the lessor. (IRS- Internal Revenue Service)

4) Net Lease: A lease wherein payments to the lessor do not include insurance and maintenance,
which are paid separately by the lessee.

5) Open-end Lease: A conditional sale lease in which the lessee guarantees that the lessor will
realize a minimum value from the sale of the asset at the end of the lease.

6) Sales-type Lease: A lease by a lessor who is the manufacturer or dealer, in which the lease
meets the definitional criteria of a capital lease or direct financing lease.

7) Synthetic Lease: A synthetic lease is basically a financing structured to be treated as a lease

for accounting purposes, but as a loan for tax purposes. The structure is used by corporations that
are seeking off-balance sheet reporting of their asset based financing, and that can efficiently use
the tax benefits of owning the financed asset.

8) Tax Lease: A lease wherein the lessor recognizes the tax incentives provided by the tax laws
for investment and ownership of equipment. Generally, the lease rate factor on tax leases is
reduced to reflect the lessor‘s recognition of this tax incentive.
9) True Lease: A type of transaction that qualifies as a lease under the Internal Revenue Code. It
allows the lessor to claim ownership and the lessee to claim rental payments as tax deductions.

Differences between financial lease and operating lease

1. While financial lease is a long term arrangement between the lessee (user of the asset) and the
owner of the asset, whereas operating lease is a relatively short term arrangement between the
lessee and the owner of asset.

2. Under financial lease all expenses such as taxes, insurance are paid by the lessee while under
operating lease all expenses are paid by the owner of the asset.
3. The lease term under financial lease covers the entire economic life of the asset which is not
the case under operating lease.

4. Under financial lease the lessee cannot terminate or end the lease unless otherwise provided in
the contract which is not the case with operating lease where lessee can end the lease anytime
before expiration date of lease.

5. While the rent which is paid by the lessee under financial lease is enough to fully amortize the
asset, which is not the case under operating lease.

*amortization - the action or process of reducing or paying off a debt with regular payments

Regulatory frame work for Leasing in India

As there is no separate statute for leasing in India, the provisions relating to bailment in the
Indian Contract Act govern equipment leasing agreements as well section 148 of the Indian
Contract Act defines bailment as: ―The delivery of goods by one person to another, for some
purpose, upon a contract that they shall, when the purpose is accomplished, be returned or
otherwise disposed off according to the directions of the person delivering them. The person
delivering the goods is called the ‗bailor‘ and the person to whom they are delivered is called the
‗bailee‘.

Since an equipment lease transaction is regarded as a contract of bailment, the obligations of the
lessor and the lessee are similar to those of the bailor and the bailee (other than those expressly
specified in the least contract) as defined by the provisions of sections 150 and 168 of the Indian
Contract Act. Essentially these provisions have the following implications for the lessor and the
lessee.

1. The lessor has the duty to deliver the asset to the lessee, to legally authorise the lessee to use
the asset, and to leave the asset in peaceful possession of the lessee during the currency of the
agreement.

2. The lessor has the obligation to pay the lease rentals as specified in the lease agreement, to
protect the lessor‘s title, to take reasonable care of the asset, and to return the leased asset on the
expiry of the lease period.

Contents of a lease agreement: The lease agreement specifies the legal rights and obligations of
the lessor and the lessee. It typically contains terms relating to the following:

1. Description of the lessor, the lessee, and the equipment.

2. Amount, time and place of lease rentals payments.
3. Time and place of equipment delivery.
4. Lessee‘s responsibility for taking delivery and possession of the leased equipment.
 5. Lessee‘s responsibility for maintenance, repairs, registration, etc. and the lessor‘s right in case
of default by the lessee.
6. Lessee‘s right to enjoy the benefits of the warranties provided by the equipment
manufacturer/supplier.
7. Insurance to be taken by the lessee on behalf of the lessor.
8. Variation in lease rentals if there is a change in certain external factors like bank interest rates,
depreciation rates, and fiscal incentives.
9. Options of lease renewal for the lessee.
10. Return of equipment on expiry of the lease period.
11. Arbitration procedure in the event of dispute.
Problems of leasing in India

Leasing has great potential in India. However, leasing in India faces serious handicaps which
may bar its growth in future. The following are the some of the problems.

1. Unhealthy competition – There is over supply of lessor in India. The stiff competition
between these lessors will force them to reduce their profit margin to bare minimum level. More
over subsidiaries of banks and financial institution have competitive edge over private sector
lessor due to their cheap source of finance.
2. Lack of qualified personnel- leasing requires qualified and experienced personnel at the helm
of its affairs. In India, leasing is of recent one and hence it is difficult to get right man to deal
with leasing business.
3. Tax Consideration- In reality, the lessee‘s tax shelter is lessors‘ burden. The lease becomes
economically viable if lessor‘s effective tax rate is low. more over taxes like sales tax, wealth
tax, additional tax , surcharge etc, add to the cost of leasing. It makes leasing relatively more
expensive.
4. Stamp Duty- States treats the leasing transaction as a sale for the purpose of making them
eligible to sales tax. On the contrary, for stamp duty, the transaction is treated as pure lease
transactions. Accordingly heavy stamp duty imposed on lease document.
5. Delayed payment and bad debts- The problem of delayed payment of rents and bad debts
add to the cost of lease. This problem would disturb prospects of leasing business.
Hire Purchase

Concept and Meaning of Hire Purchase

Hire purchase is a type of installment credit under which the hire purchaser, called the hirer,
agrees to take the goods on hire at a stated rental, which is inclusive of the repayment of
principal as well as interest, with an option to purchase. Under this transaction, the hire purchaser
acquires the property (goods) immediately on signing the hire purchase agreement but the
ownership or title of the same is transferred only when the last installment is paid.
The hire purchase system is regulated by the Hire Purchase Act 1972. This Act defines a hire
purchase as ―An agreement under which goods are let on hire and under which the hirer has an
option to purchase them in accordance with the terms of the agreement and includes an
agreement under which:

1) The owner delivers possession of goods thereof to a person on condition that such person pays
the agreed amount in periodic installments.
2) The property in the goods is to pass to such person on the payment of the last of such
installments, and
3) Such person has a right to terminate the agreement at any time before the property so passes‖.
Legal framework of Hire purchase transactions

The hire purchase system is regulated by the Hire Purchase Act 1972. In a hire-purchase
transaction, assets are let on hire, the price is to be paid in installments and hirer is allowed an
option to purchase the goods by paying all the installments. A Hire Purchase agreement usually
requires the customer to pay an initial deposit, with the remainder of the balance, plus interest,
paid over an agreed period of time. Under hire purchase agreement, you:

1. Purchase goods through installment payments

2. Use the goods while paying for them
3. Do not own the goods until you have paid the final installment
Rights of the hirer

The hirer usually has the following rights:

1. To buy the goods at any time by giving notice to the owner and paying the balance of the HP
price less a rebate
2. To return the goods to the owner — this is subject to the payment of a penalty.
3. with the consent of the owner, to assign both the benefit and the burden of the contract to a
third person.
4. Where the owner wrongfully repossesses the goods, either to recover the goods plus damages
for loss of quiet possession or to damages representing the value of the goods lost.
Additional rights

1. Rights of protection
2. Rights of notice
3. Rights of repossession
4. Rights of Statement
5. Rights of excess amount

Obligations of hirer
The hirer usually has following obligations:

1. To pay hire installments,

2. To take reasonable care of the goods
3. To inform the owner where goods will be kept. Owner‘s rights
The owner usually has the right to terminate agreement where hirer defaults in paying the
installments or breaches any of the other terms in agreement.

This entitles the owner:

1. To forfeit the deposit.

2. To retain the installments already paid and recover the balance due.
3. To repossess the goods (which may have to be by application to a Court depending on the
nature of the goods and the percentage of the total price paid.
4. To claim damages for any loss suffered.
Features of Hire Purchase

1. Immediate possession-under HP, the buyer takes immediate possession of goods by paying
only a portion of its price.
2. Hire Charges- under HP, each installment is treated as hire charges.
3. Property in goods - ownership is–passed to the hirer only after paying last or specified
number of installments
4. Down payment- hirer has to pay 20 to 25% of asset price to the vendor as down payment.
5. Repossession- Hire vendor, if default in payment of installment made by hirer, can reposes the
goods and he can resell the goods.
6. Return of goods- hirer is free to return the goods without being required to pay further
installment falling due after the return.
7. Depreciation- depreciation and investment allowances can be claimed by the hirer even
though he is not an exact owner.
Hire purchase should be distinguished from installment sale wherein property passes to the
purchaser with the payment of the first installment. But in case of HP (ownership remains with
the seller until the last installment is paid) buyer gets ownership after paying the last installment.
HP also differs from leasing

Differences between lease and Hire purchase

1. Ownership- in lease, ownership rests with the lessor throughout and the hirer of the goods not
becomes owner till the payment of specified instalments.
2. Method of financing- leasing is a method of financing business assets whereas HP is
financing both business and non-business assets.
3. Depreciation- in leasing, depreciation and investment allowances cannot be claimed by the
lessee, in HP, depreciation and IA can be claimed by the hirer.
4. Tax benefits- the entire lease rental is tax deductible expense. Only the interest component of
the HP installment is tax deductible.
5. Salvage value- the lessee, not being the owner of the asset, doesn‘t enjoy the salvage value of
the asset. The hirer, in HP, being the owner of the asset, enjoys salvage value of the asset.
6. Deposit- lessee is not required to make any deposit whereas 20% deposit is required in HP.
7. Nature of deal - with lease we rent and with HP we buy the goods.
8. Extent of Finance- in lease financing is 100 % financing since it is required down payment,
whereas HP requires 20 to 25% down payment.
9. Maintenance- cost of maintenance hired assets is borne by hirer and the leased asset (other
than financial lease) is borne by the lessor.
10. Reporting- HP assets is a balance sheet item in the books of hirer where as leased assets are
shown as off- balance sheet item (shown as Foot note to BS)
RBI guidelines for HP business

Under section 6(I)(0) of Banking Regulation Act-1949, the Govt. Of India has permitted banks to
engage in HP business. Following are some of the important guidelines of RBI for HB business
of banks;

1. Banks shall not themselves undertake directly (departmentally) the business of hire purchases.
2. Banks desirous of undertaking HP business through an existing companies or new subsidiaries
will require prior approval of RBI.
3. Banks investments in the shares of subsidiaries engaging in leasing and HP business shall not
exceed 10% of the paid up share capital and reserves of the banks.
4. Without prior approval of RBI, banks shall not act as promoters of other hire purchase
companies.
5. Prior clearance of RBI is required for the purpose of any application to the Controller of
Capital issue in case of IPO of new subsidiary and FPO of existing subsidiaries of Banks.
6. Bank shall furnish necessary information regarding its HP or equipment leasing subsidiaries,
as and when RBI demands.
Advantages of HP:

1. Spread the cost of finance – Whilst choosing to pay in cash is preferable,. A hire purchase
agreement allows a consumer to make monthly repayments over a pre-specified period of time;
2. Interest-free credit – Some merchants offer customers the opportunity to pay for goods and
services on interest free credit.
3. Higher acceptance rates –The rate of acceptance on hire purchase agreements is higher than
other forms of unsecured borrowing because the lenders have collateral.
4. Sales – A hire purchase agreement allows a consumer to purchase sale items when they aren‘t
in a position to pay in cash.
5. Debt solutions -Consumers that buy on credit can pursue a debt solution, such as debt
engagement plan, should they experience money problems further down the line.
Problems of HP business in India

Hire purchase transactions are very uncommon transactions in India. Meaning there by the
awareness of this concept is very lesser in India. All segment of India‘s population treat the hire
purchase transaction as a hypothecation loan but there is a slight differentiation among all
processes related to hire purchases. Almost for the population of India the hire purchase
transaction is very similar to the loans & hypothecation. Person who wants to purchase any asset
then the best option & way for him or her would be loan or hypothecation. Because the public is
not aware with transaction named hire purchases. Hire purchase transaction is of two types the
cash credit & asset hire purchases. People do not go for hire purchases in India because in India
business people are very less so they can not hire the assets for a longer period of time. Finally,
we would like to end up over here that, lack of awareness leads to occurrence of problem in
dealing with hire purchase.

Other problems of HP are as follows:

1. Personal debt - A hire purchase agreement is yet another form of personal debt it is monthly
repayment commitment that needs to be paid each month;
2. Final payment - A consumer doesn‘t have legitimate title to the goods until the final monthly
repayment has been made;
3. Bad credit - All hire purchase agreements will involve a credit check. Consumers that have a
bad credit rating will either be turned down or will be asked to pay a high interest rate;
4. Creditor harassment - Opting to buy on credit can create money problems should a family
experience a change of personal circumstances;
5. Repossession rights - seller is entitled to ‗snatch back‘ any goods when less than a third of the
amount has been paid back.

Factoring

When a firm sells goods on credit, cash is not received immediately. This means there is a time
gap between sale of goods/services and receipt of cash out of such sale. The outstanding
amounts get blocked for a period. This period depends upon the credit period allowed to buyers.
The outstanding amounts are called ‗Debtors‘ or ‗Accounts Receivables‘. If the debts are not
collected in time, the firm will be handicapped due to lack of sufficient working capital. The
other side is that if the debts were collected speedily the amount could be used productively.
Further, it is very difficult to collect debts. Moreover, there is the problem of defaults (i.e. bad
debts). In short, debtors or accounts receivables involve risks. So, business enterprises are
always looking for selling the debtors for cash, even at a discount. This is possible through a
financial service. Such a financial service is known as factoring.
Factoring is one of the oldest forms of commercial finance. Some scholars trace its origin to the
Roman Empire. Some others trace its origin even further back to Hammurabi, 4000 years ago.

Meaning and Definition of Factoring

Factoring provides resources to finance receivables. It also facilitates the collection of

receivables. The word factor is derived from the Latin word facere. It means to make or do or to
get things done. Factoring simply refers to selling the receivables by a firm to another party. The
buyer of the receivables is called the factor. Thus factoring refers to the agreement in which the
receivables are sold by a firm (client) to the factor (financial intermediary). The factor can be a
commercial bank or a finance company. When receivables are factored, the factor takes
possession of the receivables and generally becomes responsible for its collection. It also
undertakes administration of credit i.e. credit control, sales accounting etc.

Thus factoring may be defined as selling the receivables of a firm at a discount to a financial
organisation (factor). The cash from the sale of the receivables provides finance to the selling
company (client). Out of the difference between the face value of the receivables and what the
factor pays the selling company (i.e. discount), it meets its expenses (collection, accounting etc.).
The balance is the profit of the factor for the factoring services.

Factoring can take the form of either a factoring agreement or an assignment (pledging)
agreement. The factoring agreement involves outright sale of the firm‘s receivables to a finance
company (factor) without recourse. According to this agreement the factor undertakes the
receivables, the credit, the collection task, and the risk of bad debt. The firm selling its
receivables (client) receives the value of the receivables minus a commission charge as
compensation for the risks the factor assumes. Thereafter, customers make direct payments to the
factor. In some cases receivables are sold to factor at a discount. In this case factor does not get
commission. The discount is its commission. From this its expenses and losses (collection, bad
debt etc.) are met. The balance represents the profit of the factor.

In an assignment (pledging) agreement, the ownership of the receivables is not transferred; the
receivables are given to a finance company (factor) with recourse. The factor advances some
portion of the receivables value, generally in the range of 50 – 80%. The firm (client) is
responsible for service charges and interest on the advance (due to the factor) and losses due to
bad debts. According to this arrangement, customers make direct payment to the client.

It should be noted that both factoring and securitisation provide financing source for receivables.
In factoring, the financing source is the factor. But in securitisation, the public (investors) who
buys the securities is the factoring source.

Objectives of Factoring
Factoring is a method of converting receivables into cash. There are certain objectives of
factoring. The important objectives are as follows:

1. To relieve from the trouble of collecting receivables so as to concentrate in sales and other
major areas of business.

2. To minimize the risk of bad debts arising on account of non-realisation of credit sales.

3. To adopt better credit control policy.

4. To carry on business smoothly and not to rely on external sources to meet working capital
requirements.

5. To get information about market, customers‘ credit worthiness etc. so as to make necessary
changes in the marketing policies or strategies.

Types of Factoring

There are different types of factoring. These may be briefly discussed as follows:

1. Recourse Factoring: In this type of factoring, the factor only manages the receivables without
taking any risk like bad debt etc. Full risk is borne by the firm (client) itself.

2. Non-Recourse Factoring: Here the firm gets total credit protection because complete risk of
total receivables is borne by the factor. The client gets 100% cash against the invoices (arising
out of credit sales by the client) even if bad debts occur. For the factoring service, the client pays
a commission to the factor. This is also called full factoring.

3. Maturity Factoring: In this type of factoring, the factor does not pay any cash in advance.
The factor pays clients only when he receives funds (collection of credit sales) from the
customers or when the customers guarantee full payment.

4. Advance Factoring: Here the factor makes advance payment of about 80% of the invoice
value to the client.

5. Invoice Discounting: Under this arrangement the factor gives advance to the client against
receivables and collects interest (service charge) for the period extending from the date of
advance to the date of collection.

6. Undisclosed Factoring: In this case the customers (debtors of the client) are not at all
informed about the factoring agreement between the factor and the client. The factor performs all
its usual factoring services in the name of the client or a sales company to which the client sells
its book debts. Through this company the factor deals with the customers. This type of factoring
is found in UK.
7. Cross border factoring: It is similar to domestic factoring except that there are four parties,
viz,

a) Exporter,
b) Export Factor,
c) Import Factor, and
d) Importer.
It is also called two-factor system of factoring. Exporter (Client) enters into factoring
arrangement with Export Factor in his country and assigns to him export receivables. Export
Factor enters into arrangement with Import Factor and has arrangement for credit evaluation &
collection of payment for an agreed fee. Notation is made on the invoice that importer has to
make payment to the Import Factor. Import Factor collects payment and remits to Export Factor
who passes on the proceeds to the Exporter after adjusting his advance, if any. Where foreign
currency is involved, factor covers exchange risk also.

Process of Factoring (Factoring Mechanism)

The firm (client) having book debts enters into an agreement with a factoring agency/institution.
The client delivers all orders and invoices and the invoice copy (arising from the credit sales) to
the factor. The factor pays around 80% of the invoice value (depends on the price of factoring
agreement), as advance. The balance amount is paid when factor collects complete amount of
money due from customers (client‘s debtors). Against all these services, the factor charges some
amounts as service charges. In certain cases the client sells its receivables at discount, say, 10%.
This means the factor collects the full amount of receivables and pays 90% (in this case) of the
receivables to the client. From the discount (10%), the factor meets its expenses and losses. The
balance is the profit or service charge of the factor. Thus there are three parties to the factoring.
They are the buyers of the goods (client‘s debtors), the seller of the goods (client firm i.e. seller
of receivables) and the factor. Factoring is a financial intermediary between the buyer and the
seller.

Features (Nature) of Factoring

From the following essential features of factoring, we can understand its nature:

1. Factoring is a service of financial nature. It involves the conversion of credit bills into cash.
Account receivables and other credit dues resulting from credit sales appear in the books of
account as book credits.

2. The factor purchases the credit/receivables and collects them on the due date. Thus the risks
associated with credit are assumed by the factor.
3. A factor is a financial institution. It may be a commercial bank or a finance company. It offers
services relating to management and financing of debts arising out of credit sales. It acts as a
financial intermediary between the buyer (client debtor) and the seller (client firm).

4. A factor specialises in handling and collecting receivables in an efficient manner.

5. Factor is responsible for sales accounting, debt collection, credit (credit monitoring),
protection from bad debts and rendering of advisory services to its clients.

6. Factoring is a technique of receivables management. It is used to release funds tied up in

receivables (credit given to customers) and to solve the problems relating to collection, delays
and defaults of the receivables.

Functions of a Factor

Factor is a financial institution that specialises in buying accounts receivables from business
firms. A factor performs some important functions. These may be discussed as follows:

1. Provision of finance: Receivables or book debts is the subject matter of factoring. A factor
buys the book debts of his client. Generally a factor gives about 80% of the value of receivables
as advance to the client. Thus the nonproductive and inactive current assets i.e. receivables are
converted into productive and active assets i.e. cash.

2. Administration of sales ledger: The factor maintains the sales ledger of every client. When
the credit sales take place, the firm prepares the invoice in two copies. One copy is sent to the
customers. The other copy is sent to the factor. Entries are made in the ledger under open-item
method. In this method each receipt is matched against the specific invoice. The customer‘s
account clearly shows the various open invoices outstanding on any given date. The factor also
gives periodic reports to the client on the current status of his receivables and the amount
received from customers. Thus the factor undertakes the responsibility of entire sales
administration of the client.

3. Collection of receivables: The main function of a factor is to collect the credit or receivables
on behalf of the client and to relieve him from all tensions/problems associated with the credit
collection. This enables the client to concentrate on other important areas of business. This also
helps the client to reduce cost of collection.

4. Protection against risk: If the debts are factored without resource, all risks relating to
receivables (e.g., bad debts or defaults by customers) will be assumed by the factor. The factor
relieves the client from the trouble of credit collection. It also advises the client on the
creditworthiness of potential customers. In short, the factor protects the clients from risks such as
defaults and bad debts.
5. Credit management: The factor in consultation with the client fixes credit limits for
approved customers. Within these limits, the factor undertakes to buy all trade debts of the
customer. Factor assesses the credit standing of the customer. This is done on the basis of
information collected from credit relating reports, bank reports etc. In this way the factor
advocates the best credit and collection policies suitable for the firm (client). In short, it helps the
client in efficient credit management.

6. Advisory services: These services arise out of the close relationship between a factor and a
client. The factor has better knowledge and wide experience in the field of finance. It is a
specialised institution for managing account receivables. It possesses extensive credit
information about customer‘s creditworthiness and track record. With all these, a factor can
provide various advisory services to the client. Besides, the factor helps the client in raising
finance from banks/financial institutions.

Advantages of Factoring

A firm that enters into factoring agreement is benefited in a number of ways. Some of the
important benefits of factoring are summarised as follows:

1. Improves efficiency: Factoring is an important tool for efficient receivables management.

Factors provide specialised services with regard to sales ledger administration, credit control etc.
Factoring relieves the clients from botheration of debt collection.

2. Higher credit standing: Factoring generates cash for the selling firm. It can use this cash for
other purposes. With the advance payment made by factor, it is possible for the client to pay off
his liabilities in time. This improves the credit standing of the client before the public.

3. Reduces cost: The client need not have a special administrative setup to look after credit
control. Hence it can save manpower, time and effort. Since the factoring facilitates steady and
reliable cash flows, client can cut costs and expenses. It can avail cash discounts. Further, it can
avoid production delays.

4. Additional source: Funds from a factor is an additional source of finance for the client.
Factoring releases the funds tied up in credit extended to customers and solves problems relating
to collection, delays and defaults of the receivables.

5. Advisory service: A factor firm is a specialised agency for better management of receivables.
The factor assesses the financial, operational and managerial capabilities of customers. In this
way the factor analyses whether the debts are collectable. It collects valuable information about
customers and supplies the same for the benefits of its clients. It provides all management and
administrative support from the stage of deciding credit extension to the customers to the final
stage of debt collection. It advocates the best credit policy suitable for the firm.
6. Acceleration of production cycle: With cash available for credit sales, client firm‘s liquidity
will improve. In this way its production cycle will be accelerated.

7. Adequate credit period for customers: Customers get adequate credit period for payment of
assigned debts.

8. Competitive terms to offer: The client firm will be able to offer competitive terms to its
buyers. This will improve its sales and profits.

Limitations of Factoring

The main limitations of factoring are outlined as below:

1. Factoring may lead to over-confidence in the behaviour of the client. This results in
overtrading or mismanagement.

2. There are chances of fraudulent acts on the part of the client. Invoicing against non-existent
goods, duplicate invoicing etc. are some commonly found frauds. These would create problems
to the factors.

3. Lack of professionalism and competence, resistance to change etc. are some of the problems
which have made factoring services unpopular.

4. Factoring is not suitable for small companies with lesser turnover, companies with speculative
business, companies having large number of debtors for small amounts etc.

5. Factoring may impose constraints on the way to do business. For non - recourse factoring most
factors will want to pre- approve customers. This may cause delays. Further, the factor will
apply credit limits to individual customers.

Forfaiting

Generally there is a delay in getting payment by the exporter from the importer. This makes it
difficult for the exporter to expand his export business. However, for getting immediate
payment, the concept of forfeiting shall come to the help of exporters.

The concept of forfaiting was originally developed to help finance German exports to Eastern
bloc countries. In fact, it evolved in Switzerland in mid 1960s.

Meaning of Forfaiting

The term ‗forfait‘ is a French world. It means ‗to surrender something‘ or ‗give up one‘s right‘.
Thus forfaiting means giving up the right of exporter to the forfaitor to receive payment in future
from the importer. It is a method of trade financing that allows exporters to get immediate cash
and relieve from all risks by selling their receivables (amount due from the importer) on a
‗without recourse‘ basis. This means that in case the importer makes a default the forfaitor
cannot go back to the exporter to recover the money. Under forfaiting the exporter surrenders
his right to a receivable due at a future date in exchange for immediate cash payment, at an
agreed discount. Here the exporter passes to the forfaitor all risks and responsibilities in
collecting the debt. The exporter is able to get 100% of the amount of the bill immediately.
Thus he gets the benefit of cash sale. However, the forfaitor deducts the discount charges and he
gives the balance amount to the exporter. The entire responsibility of recovering the amount
from the importer is entrusted with the forfaitor. The forfaitor may be a bank or any other
financial institution.

In short, the non-recourse purchase of receivables arising from an export of goods and services
by a forfaitor is known as forfaiting.

Forfaiting is not the same as international factoring. The tenure of forfaiting transaction is long.
International factoring involves short term trade transactions. In case of forfaiting, political and
transfer risks are also borne by the forfaitor. But in international factoring these risks are not
borne by the factor.

Characteristics of Forfaiting

The main characteristics of forfaiting are:

1. It is 100% financing without recourse to the exporter.

2. The importer‘s obligation is normally supported by a local bank guarantee (i.e., ‗aval‘).

3. Receivables are usually evidenced by bills of exchange, promissory notes or letters of credit.

4. Finance can be arranged on a fixed or floating rate basis.

5. Forfaiting is suitable for high value exports such as capital goods, consumer durables,
vehicles, construction contracts, project exports etc.

6. Exporter receives cash upon presentation of necessary documents, shortly after shipment.

Advantages of Forfaiting

The following are the benefits of forfaiting:

1. The exporter gets the full export value from the forfaitor.
2. It improves the liquidity of the exporter. It converts a credit transaction into a cash
transaction.
3. It is simple and flexible. It can be used to finance any export transaction. The structure of
finance can be determined according to the needs of the exporter, importer, and the forfaitor.
4. The exporter is free from many export credit risks such as interest rate risk, exchange rate risk,
political risk, commercial risk etc.
5. The exporter need not carry the receivables into his balance sheet.
6. It enhances the competitive advantage of the exporter. He can provide more credit. This
increases the volume of business.
7. There is no need for export credit insurance. Exporter saves insurance costs. He is relieved
from the complicated procedures also.
8. It is beneficial to forfaitor also. He gets immediate income in the form of discount. He can
also sell the receivables in the secondary market or to any investor for cash.

Difference between Factoring and Forfaiting

Forfaiting and factoring have similarities. Both have similar features of advance payment and
non-recourse dealing. But there are some differences between them. The differences are as
follows:

Factoring Forfaiting

1. Used for short term financing. 1. Used for medium term financing.

2. May be with or without recourse. 2. Always without recourse.

3. Applicable to both domestic and export 3. Applicable to export receivables only.

receivables.

4. Normally 70 to 85% of the invoice value is 4. 100% finance is provided to the exporter.
provided as advance.

5. The contractor is between the factor and the 5. The contract is between the forfaitor and the
seller. exporter.

6. Other than financing, several other things 6. It is a financing arrangement only.

like sales ledger administration, debt collection
etc. is provided by the factor.

7. A bulk finance is provided against a number 7. It is based on a single export bill resulting
of unpaid invoices. from only a single transaction.
8. No minimum size of transaction is specified. 8. There is a minimum specified value per
transaction.

Bills discounting

Bill discounting is book debt financing. This is done by commercial banks.

Meaning of Bills Discounting

When goods are sold on credit, the receivables or book debts are created. The supplier or seller
of goods draws a bill of exchange on the buyer or debtor for the invoice price of the goods sold
on credit. It is drawn for a short period of 3 to 6 months. Sometimes it is drawn for 9 months.
After drawing the bill, the seller hands over the bill to the buyer. The buyer accepts the same.
This means he binds himself liable to pay the amount on the maturity of the bill. After accepting
the bill, the buyer (drawee) gives the same to the seller (drawer). Now the bill is with the
drawer. He has three alternatives.

One is to retain the bill till the due date and present the bill to the drawee and receive the amount
of the bill. This will affect the working capital position of the creditor. This is because he does
not get immediate payment. The second alternative is to endorse the bill to any creditors to settle
the business obligation. The third or last alternative is to discount the bill with his banker. This
means he need not wait till the due date. If he is in need of money, he can discount the bill with
his banker. The banker deducts certain amount as discount charges from the amount of the bill
and balance is credited in the customer‘s (drawer‘s or holders) account.

Thus the bank provides immediate cash by discounting trade bills. In other words, the banker
advances money on the security of bill of exchange. On the due date, the banker presents the bill
to the drawee and receives payment. If the drawee does not make payment, the drawer has to
make payment to the banker. Here the bank is the financier. It renders financial service. In
short, discounting is a financial service.

Advantages of Bill Discounting/Bill Financing

1. It offers high liquidity. The seller gets immediate cash.

2. The banker gets income immediately in the form of discount.
3. Bills are not subject to any fluctuations in their values.
4. Procedures are simple.
5. Even if the bill is dishonored, there is a simple legal remedy. The banker has to simply note
and protest the bill and debit in the customer‘s account.
6. The bills are useful as a base for the maintenance of reserve requirements like CRR and SLR.
Difference between Bill Discounting and Factoring

Bills Discounting Factoring

Finance alone is provided. In addition to the provision of finance, several

other services like maintenance of sales ledger,

advisory services etc. are provided.

Advances are made against bills. Receivables are purchased by assignment

Drawer or holder is the collector of Factor is the collector of receivables.

receivables.
It is individual transaction-oriented. Bulk finance is provided (i.e., based on

whole turnover).

It is not an off-balance sheet method of It is off-balance sheet method finance.

finance.

Stamp duty is charged on bills. No stamp duty is charged on invoices.

The grace period for payment is usually 3 days. The grace period is higher.

Does not involve assignment of debts. It involves assignment of debts.

Bills discounted may be rediscounted several Debts purchased cannot be rediscounted; they
times before the due date. can only be refinanced.

It is always with recourse. It may be with or without recourse.

Housing Finance

Housing finance simply refers to providing finance for house building. It emerged as a fund
based financial service in India with the establishment of National Housing Bank (NHB) by the
RBI in 1988. It is an apex housing finance institution in the country. Till now, a number of
specialised financial institutions/companies have entered in the field of housing finance. Some of
the institutions are HDFC, LIC Housing Finance, Citi Home, Ind Bank Housing etc

Housing Finance—A Dominant Retail Financing

Today one can witness a paradigm shift to housing finance. Housing finance has become a
lucrative business to many banking and non-banking companies. Almost all financial institutions
seem to concentrate on ‗retail financing‘ rather than ‗wholesale financing‘. Lending to corporates
and big institutional borrowers is called wholesale lending or financing. On the other hand,
lending to individuals and group of individuals come under the category of ‗retail financing‘.

In retail financing, housing finance grows at an impressive rate due to various reasons. Easy
access at affordable rates has accelerated the tempo of housing activities in recent times.
Different financial products have been introduced to cater to the vast housing requirements of
varied people. Housing loans are given not only for construction, but also for extension,
improvements etc. Loans are given for furnishing houses and also for paying stamp duties. Banks
have come forward to waive the processing fees. Housing loans are sanctioned with flexible
repayment schedule which can be decided by the customers themselves. Housing loans are
sanctioned for family planning clinics, health centers, educational, social, and cultural and other
institutions also. Shopping centers in residential areas can also avail of housing loan facilities.

Housing / home loan products

Generally, the following financial products are available in the housing market.

(i)Housing loan for purchase of homes – This product is available purely for the purchase of
either new houses or flats or existing ones.

(ii)House construction loan –This product is available only for the construction of new houses.

(iii) Home extension loan-This is available purely for expanding an already existing home.

(iv) Home improvement loan – This is granted for renovating an existing home.

(v)Flexible repayment plan – This type of housing loan permits the borrower to fix the
repayment schedule as per his option.
(vi) Flexible loan installment plan – Under this type of housing loan, the borrower can decide
the amount of installment to be paid according to his discretion on the basis of his future
earnings.

(vii)Home transfer or conversion loan – This product is available to those who have already
availed of housing loans and want to move to another house for which additional funds are
required. Under this type, the existing housing loan is transferred to the new housing loan
amount without the necessity of settling the previous loan account.

(viii)Home furnishing loan – This product is available to furnish a house fully.

(ix) Housing repayment or refinance loan – This loan is available to redeem the prior debts
incurred for the purchase of homes from friends, relatives and other private sources.

(x) Housing loan transfer plan – This loan is available to pay off an existing housing loan with
a higher interest rate and enjoy a new loan with a lower rate of interest.

(xi) Bridge loan for housing – This product is available to those who wish to sell their old
homes and purchase another. This loan is available for the new home until a suitable buyer is
found for the old home.

(xii) Stamp duty /Documenting Loan- this is the HL product meant for payment of stamp duty
and other documentation charges in connection with house purchases.

Housing finance institutions

A number of institutions play a dominant role in the field of housing finance. The most important
ones are the following:

I. National Housing Bank (NHB)

The National Housing Bank was set up on July 9, 1988 as an apex institution to mobilize
resources for the housing sector and to promote housing finance institutions, both on regional
and local levels. It was established as a subsidiary of the RBI with a view to coordinating and
developing housing finance schemes. Following are the main functions of the NHB:

(i)To promote and develop specialized housing finance institutions for mobilizing resources and
supplying credit for house construction.
(ii) To provide refinance facilities to housing finance institutions and scheduled banks.
(iii) To provide guarantee and underwriting facilities to housing finance institutions.
(iv) To promote schemes for mobilization of resources and extension of credit for housing
especially for economically weaker sections of the society.
(v) To co-ordinate the working of all agencies connected with housing.
II. Commercial Banks

For a long time, the commercial banks were rather reluctant to enter into the field of housing
finance since it is of a long-term nature. But, today, both public and private sector banks have
changed their outlook completely and they have started to look at housing finance as a very
lucrative business. Many banks have set up their own subsidiaries exclusively for providing
housing finance especially to meet the housing requirements of the lower and middle income
groups. Some of the subsidiaries established by commercial banks to provide housing finance are
the following:

Name of the Bank Name of the Housing Finance Company (Subsidiary companies)
(i) State Bank of India State Bank of India Housing Finance (SBIHF)
(ii) Punjab National Bank Punjab National Bank Housing Finance Ltd. (PNBHFL)
(iii) Andhra Bank Andhra Bank Housing Finance Ltd. (AHFL)
(v) Canara Bank Can Fin Homes Ltd. (CFHL)
(vii) Vijaya Bank VBank Housing Finance Ltd. (VHFL)
(viii) Bank of India Indian Bank Housing Finance Ltd. (IBHFL)
III. Cooperative Banks
Besides providing finance, these banks/ societies pay a special attention to the provision of all
amenities necessary for a comfortable living. These societies also extend finance for purchase of
residential plots developed by them. The State Level Apex Co-operative Housing Finance
Society(ACHFS) co-ordinates the housing financial requirements of various cooperative housing
societies. It is eligible to get refinance facility from the NHB.

IV. Housing and Urban Development Corporation Ltd. (HUDCO)

The HUDCO was incorporated as a fully owned Government Company with the main objective
of financing the urban infrastructure development projects, approved by the Government. Since
the problem of housing is very acute in urban areas, it concentrates on urban development
projects by providing shelter to the poor and for low income groups. It is the nodal agency for
implementing various government housing programmes.

V. Housing Development Finance Corporation (HDFC) and other Private Finance

Companies
The Housing Development and Finance Corporation (HDFC) was set up in the private sector in
1977 by institutions like ICICI, IFC (International Finance Corporation) etc. Today it has
become the largest provider of housing finance in India. It has pioneered a variety of housing
loans like group loans, housing complexes, housing societies etc. It lends to companies
employers and institutions to finance their house construction requirements for their employees,
staff quarters etc. It also provides loans to individuals, groups and societies. Apart from the
HDFC, many housing finance corporations have come into existence in the private sector. Some
of these institutions are:

a. Birla Home Finance Ltd. (NHFL)

b. Sundaram Home Finance Ltd. (SHFL)
c. Global Housing Finance Corporation Ltd. (GHFCL)
d. Dewan Housing Finance Corporation Ltd. (DHFCL)
e. Maharishi Housing Finance Corporation Ltd. (MHFCL)
f. Home Trust Housing Finance Corporation Ltd. (HHFCL).
These institutions have designed some innovative housing finance products so as to cater to the
requirements of various types of borrowers.

VI. Insurance companies

The LIC has set up the LIC Housing Finance Ltd. in 1989 with the objective of providing long-
term finance for purchase/construction of houses/flats to its policyholders directly throughout
India. It offers a variety of housing loans for re-constructions, renovations etc. It has designed
special schemes for professionals, NRIs etc.

The General Insurance Corporation is also actively engaged in providing housing finance
indirectly through other institutions like HUDCO or through State Governments. It has also set
up a separate company viz., GIC Housing Finance Ltd. to activate the home loan process. Thus,
the insurance companies have emerged as vibrant housing finance institutions in recent years.

Reasons for the Popularity of Housing Finance (Advantages)

The bank finance to the housing sector has become an attractive channel due to the following
reasons:

(i)Safety Advances: Housing finance, though a long-term finance is considered to be a safe

advance since it is backed by mortgage of house.

(ii) Refinance Facility: Almost all banks are eligible to get refinance from the NHB for their
advances to the housing sector. Hence, there will be no financial crunch on the part of the
bankers.

(iii) Asset-Liability Management (ALB): The longer tenures of housing finance facilitate ALB.
Since the RBIs guidelines permit banks to elongate repayment periods quoting variable interest
rates, the ALM becomes an easy task.

(iv) Priority Sector Advance: Housing loans up to Rs.10 lakhs have been brought under the
category of priority sector advances. It enables the commercial banks to fulfill their priority
sector advances target.
(v) Low Default: Banks have found out that the default risk is very low in the case of housing
finance. Hence, there is no problem of NPA management.

(vi) Reduction in Risk Weightage: Again, the RBI has reduced the risk weightage from 100%
to 50% for loans granted for acquiring residential houses. It helps commercial banks to satisfy
the capital adequacy norms also.

(vii) Passing of SARFAESl Act-2002: The passing of the Securitization and Reconstruction of
Financial Assets and Enforcement of Security Interest Act has paved way for the commercial
banks to directly deal with the security by giving wide process, instead of undergoing a
cumbersome procedure of approaching a court to deal with such securities in case any default is
committed by borrowers.

(viii) Establishment of Asset Reconstruction Company (ARC): The establishment of ARC

has given another boost to housing finance since it facilitates securitization of mortgaged
housing loans.

(x) Mortgaged Credit Guarantee Scheme: The NHB has come forward to give guarantee to
the debentures, bonds and other securities issued by commercial banks for the purpose of raising
adequate resources for housing finance.

Today, housing finance is no longer a risky advance. It has become a very lucrative business for
bankers. The RBI has deregulated the interest rates giving greater freedom to banks to price their
housing financial products according to their discretion.

Venture Capital

There are some businesses that involve higher risks. In the case of newly started business, the
risk is more. The new businesses may be promoted by qualified entrepreneurs. They lack
necessary experience and funds to give shape to their ideas. Such high risk, high return ventures
are unable to raise funds from regular channels like banks and capital markets.

Generally people would not like to invest in new high risk companies. Some people invest
money in such new high risk companies. Even though the risk is high, there is a potential of
getting a return of ten times more in less than five years. The investors making such investments
are called venture capitalists. The money invested in new, high risk and high return firms is
called venture capital. Venture capitalists not only provide money but also help the entrepreneur
with guidance in formalizing his ideas into a viable business venture. They get good return on
their investment. The percentage of the profits the venture capitalists get is called the carry.

Origin/History of Venture Capital

In the 1920‘s and 1930‘s, the wealthy families of individual investors provided the start-up
money for companies that would later become famous. Eastern Airlines and Xerox are the more
famous ventures they financed. Among the early VC fund set-ups was the one by the Rockfeller
family which started a special fund called Venrock in 1950, to finance new technology
companies. General Georges Doriot (the father of venture capital), a professor at Harvard
Business School, in 1946 set up the American Research and Development Corporation (ARD).
ARD‘s approach was a classic VC in the sense that it used only equity, invested for long term.
ARD‘s investment in Digital Equipment Corporation (DEC) in 1957 was a watershed in the
history of VC financing. While in its early years VC may have been associated with high
technology, over the years, the concept has undergone a change and, as it stands today, it implies
pooled investment to unlisted companies.

Meaning of Venture Capital

The term venture capital comprises of two words, namely, ‗venture‘ and ‗capital‘. The term
‗venture‘ literally means a ‗course‘ or ‗proceeding‘, the outcome of which is uncertain (i.e.,
involving risk). The term capital refers to the resources to start the enterprise. Thus venture
capital refers to capital investment in a new and risky business enterprise. Money is invested in
such enterprises because these have high growth potential.

A young hi-tech company that is in the early stage of financing and is not yet ready to make a
public issue may seek venture capital. Such a high risk capital is provided by venture capital
funds in the form of long term equity finance with the hope of earning a high rate of return
primarily in the form of capital gain. In fact, the venture capitalist acts as a partner with the
entrepreneur.

Venture capital is the money and resources made available to start up firms and small business
with exceptional growth potential (e.g., IT, infrastructure, real estate etc.). It is fundamentally a
long term risk capital in the form of equity finance for the small new ventures which involve
risk. But at the same time, it is the strong potential for the growth. It thrives on the concept of
high risk high return. It is a means of equity financing for rapidly growing private companies.

Venture capital can be visualized as ‗your ideas and our money‘ concept of developing business.
It is ‗patient‘ capital that seeks a return through long term capital gain rather than immediate and
regular interest payments as in the case of debt financing. When venture capitalists invest in a
business, they typically require a seat on the company‘s board of directors. But professional
venture capitalists act as mentors and provide support and advice on a number of issues relating
to management, sales, technology etc. They assist the company to develop its full potential.
They help the enterprise in the early stage until it reaches the stage of profitability. When the
business starts making considerable profits and the market value of the shares go up to
considerable extent, venture capitalists sell their equity holdings at a high value and thereby
make capital gains.

In short, venture capital means the financial investment in a highly risk project with the objective
of earning a high rate of return.
Characteristics of Venture Capital

The important characteristics of venture capital finance are outlined as bellow:

1. It is basically equity finance.

2. It is a long term investment in growth-oriented small or medium firms.
3. Investment is made only in high risk projects with the objective of earning a high rate of
return.
4. In addition to providing capital, venture capital funds take an active interest in the
management of the assisted firm. It is rightly said that, ―venture capital combines the qualities of
banker, stock market investor and entrepreneur in one‖.
5. The venture capital funds have a continuous involvement in business after making the
investment.
6. Once the venture has reached the full potential, the venture capitalist sells his holdings at a
high premium. Thus his main objective of investment is not to earn profit but capital gain.

Types of Venture Capitalists

Generally, there are three types of venture capital funds. They are as follows:

1. Venture capital funds set up by angel investors (angels): They are individuals who invest
their personal capital in startup companies. They are about 50 years old. They have high income
and wealth. They are well educated. They have succeeded as entrepreneurs. They are interested
in the startup process.

2. Venture capital subsidiaries of Corporations: These are established by major corporations,

commercial banks, holding companies and other financial institutions.

3. Private capital firms/funds: The primary source of venture capital is a venture capital firm.
It takes high risks by investing in an early stage company with high growth potential.

Methods or Modes of Venture Financing (Funding Pattern)/Dimensions of Venture Capital

Venture capital is typically available in four forms in India: equity, conditional loan, income note
and conventional loan.

[Link]: All VCFs in India provide equity but generally their contribution does not exceed 49
per cent of the total equity capital. Thus, the effective control and majority ownership of the
firm remain with the entrepreneur. They buy shares of an enterprise with an intention to
ultimately sell them off to make capital gains.

[Link] loan: It is repayable in the form of a royalty after the venture is able to generate
sales. No interest is paid on such loans. In India, VCFs charge royalty ranging between 2 and 15
per cent; actual rate depends on the other factors of the venture, such as gestation period, cost-
flow patterns and riskiness.

[Link] note: It is a hybrid security which combines the features of both conventional loan and
conditional loan. The entrepreneur has to pay both interest and royalty on sales, but at
substantially low rates.

[Link] loan: Under this form of assistance, the enterprise is assisted by way of loans.
On the loans, a lower fixed rate of interest is charged, till the unit becomes commercially
operational. When the company starts earning profits, normal or higher rate of interest will be
charged on the loan. The loan has to be repaid as per the terms of loan agreement.

[Link] financing methods: A few venture capitalists, particularly in the private sector, have
started introducing innovative financial securities like participating debentures introduced by
TCFC.

Stages of Venture Capital Financing

Venture capital takes different forms at different stages of a project. The various stages in the
venture capital financing are as follows:

1. Early stage financing: This stage has three levels of financing. These three levels are:

(a) Seed financing: This is the finance provided at the project development stage. A small
amount of capital is provided to the entrepreneurs for concept testing or translating an idea into
business.

(b) Start up finance/first stage financing: This is the stage of initiating commercial production
and marketing. At this stage, the venture capitalist provides capital to manufacture a product.

(c) Second stage financing: This is the stage where product has already been launched in the
market but has not earned enough profits to attract new investors. Additional funds are needed at
this stage to meet the growing needs of business. Venture capital firms provide larger funds at
this stage.

2. Later stage financing: This stage of financing is required for expansion of an enterprise that
is already profitable but is in need of further financial support. This stage has the following
levels:

(a) Third stage/development financing: This refers to the financing of an enterprise which has
overcome the highly risky stage and has recorded profits but cannot go for public issue. Hence it
requires financial support. Funds are required for further expansion.
(b) Turnarounds: This refers to finance to enable a company to resolve its financial difficulties.
Venture capital is provided to a company at a time of severe financial problem for the purpose of
turning the company around.

(c) Fourth stage financing/bridge financing: This stage is the last stage of the venture capital
financing process. The main goal of this stage is to achieve an exit vehicle for the investors and
for the venture to go public. At this stage the venture achieves a certain amount of market share.

(d) Buy-outs: This refers to the purchase of a company or the controlling interest of a
company‘s share. Buy-out financing involves investments that might assist management or an
outside party to acquire control of a company. This results in the creation of a separate business
by separating it from their existing owners.

Advantages of Venture Capital

Venture capital has a number of advantages over other forms of finance. Some of them are:

1. It is long term equity finance. Hence, it provides a solid capital base for future growth.
2. The venture capitalist is a business partner. He shares the risks and returns.
3. The venture capitalist is able to provide strategic operational and financial advice to the
company.
4. The venture capitalist has a network of contacts that can add value to the company. He can
help the company in recruiting key personnel, providing contracts in international markets etc.
5. Venture capital fund helps in the industrialization of the country.
6. It helps in the technological development of the country.
7. It generates employment.
8. It helps in developing entrepreneurial skills.
9. It promotes entrepreneurship and entrepreneurism in the country.

Venture Capital in India

In India, the venture capital plays a vital role in the development and growth of innovative
entrepreneurships. Venture capital activity in the past was possibly done by the developmental
financial institutions like IDBI, ICICI and state financial corporations. These institutions
promoted entities in the private sector with debt as an instrument of funding.

For a long time, funds raised from public were used as a source of venture capital. And with the
minimum paid up capital requirements being raised for listing at the stock exchanges, it became
difficult for smaller firms with viable projects to raise funds from the public.

In India, the need for venture capital was recognised in the 7th five-year plan and long term fiscal
policy of the Government of India. In 1973, a committee on development of small and medium
enterprises highlighted the need to foster VC as a source of funding new entrepreneurs and
technology. VC financing really started in India in 1988 with the formation of Technology
Development and Information Company of India Ltd. (TDICI) – promoted by ICICI and UTI.

The first private VC fund was sponsored by Credit Capital Finance Corporation (CEF) and
promoted by Bank of India, Asian Development Bank and the Commonwealth Development
Corporation, namely, Credit Capital Venture Fund. At the same time, Gujarat Venture Finance
Ltd. and AFIDC Venture Capital Ltd. were started by state-level financial institutions. Sources
of these funds were the financial institutions, foreign institutional investors or pension funds and
high net worth individuals. The venture capital funds in India are listed in the following Table:

Legal Aspects of Venture Capital

The legal aspects relating to venture capital in India may be briefly explained as follows:

Regulatory Structure: The SEBI regulates venture capital industry in India. It announced the
regulations for the venture capital funds in 1996, with the primary objective of protecting the
interest of investors and providing enough flexibility to the fund managers to make suitable
investment decisions. Venture capital funds appoint an asset management company to manage
the portfolio of the fund. Any company proposing to undertake venture capital investments is
required to obtain certificate of registration from SEBI. Venture capital fund can invest up to
40% of the paid up capital of the invested company or up to 20% of the corpus of the fund in one
undertaking. At least 80% of funds raised by VCF shall be invested in equity shares or equity
related securities issued by company whose shares are not listed on recognised stock exchange.
Venture capital investments are required to be restricted to domestic companies engaged in
business of software, information technology, biotechnology, agriculture, and allied sectors.

Guidelines for the Venture Capital Companies

The Government of India has issued the following guidelines for various venture capital funds
operating in the country.

1. The financial institutions, State Bank of India, scheduled banks, and foreign banks are eligible
to establish venture capital companies or funds subject to the approval as may be required from
the Reserve Bank of India.

2. The venture capital funds have a minimum size of Rs. 10 crores and a debt equity ratio of
1:1.5. If they desire to raise funds from the public, promoters will be required to contribute
minimum of 40% of the capital.

3. The guidelines also provide for NRI investment upto 74% on a non-repatriable basis.

4. The venture capital funds should be independent of the parent organisation.

5. The venture capital funds will be managed by professionals and can be set up as joint ventures
even with non-institutional promoters.
6. The venture capital funds will not be allowed to undertake activities such as trading, broking,
and money market operations but they will be allowed to invest in leasing to the extent of 15% of
the total funds deployed. The investment or revival of sick units will be treated as a part of
venture capital activity.

7. A person holding a position of being a full time chairman, chief executive or managing
director of a company will not be allowed to hold the same position simultaneously in the
venture capital fund/company.

8. The venture capital assistance should be extended to the promoters who are now, and are
professionally or technically qualified with inadequate resources.

SEBI (Venture Capital Funds) (Amendment) Regulations, 2000 and SEBI (Foreign Venture
Capital Investors) Regulations, 2000

A. Following are the salient features of the SEBI (Venture Capital Funds) (Amendment)
Regulations, 2000:

1. Definition of venture capital fund: The venture capital fund is now defined as a fund
established in the form of a Trust, a company including a body corporate and registered with
SEBI which:

(a) has a dedicated pool of capital;

(b) raised in the manner specified under the Regulations; and
(c) to invest in venture capital undertakings in accordance with the Regulations.
2. Definition of venture capital undertaking: Venture capital undertaking means a domestic
company:

(a) Whose shares are not listed on recognised stock exchanges in India

(b) Which is engaged in business including providing services, production or manufacture of

articles or things, or does not include such activities or sectors which are specified in the
negative list by the Board with the approval of the Central Government by notification in the
Official Gazette in this behalf. The negative list includes real estate, non-banking financial
services, gold financing, activities not permitted under the Industrial Policy of the Government
of India.

3. Minimum contribution and fund size: The minimum investment in a Venture Capital Fund
from any investor will not be less than Rs. 5 lakhs and the minimum corpus of the fund before
the fund can start activities shall be at least Rs. 5 crores.

4. Investment criteria: The earlier investment criteria have been substituted by a new
investment criteria which has the following requirements:

(a) Disclosure of investment strategy;

(b) Maximum investment in single venture capital undertaking not to exceed 25% of the corpus
of the fund;

(c) Investment in the associated companies not permitted;

(d) At least 75% of the investible funds to be invested in unlisted equity shares or equity linked
instruments.

(e) Not more than 25% of the investible funds may be invested by way of;

(i)subscription to initial public offer of a venture capital undertaking whose shares are proposed
to be listed subject to lock-in period of one year.

(ii) Debt or debt instrument of a venture capital undertaking in which the venture capital fund has
already made an investment by way of equity.

It has also been provided that venture capital fund seeking to avail benefit under the relevant
provisions of the Income Tax Act will be required to divest from the investment within a period
of one year from the listing of the venture capital undertaking.

5. Disclosure and information to investors: In order to simplify and expedite the process of
fund raising, the requirement of filing the placement memorandum with SEBI is dispensed with
and instead the fund will be required to submit a copy of Placement Memorandum/copy of
contribution agreement entered with the investors along with the details of the fund raised for
information to SEBI. Further, the contents of the Placement Memorandum are strengthened to
provide adequate disclosure and information to investors. SEBI will also prescribe suitable
reporting requirement from the fund on their investment activity.

6. QIB status for venture capital funds: The venture capital funds will be eligible to participate
in the IPO through book building route as Qualified Institutional Buyer subject to compliance
with SEBI (Venture Capital Fund) Regulations.

7. Relaxation in takeover code: The acquisition of shares by the company or any of the
promoters from the Venture Capital Fund under the terms of agreement shall be treated on the
same footing as that of acquisition of shares by promoters/companies from the state level
financial institutions and shall be exempt from making an open offer to other shareholders.

8. Investments by mutual funds in venture capital funds: In order to increase the resources
for domestic venture capital funds, mutual funds are permitted to invest upto 5% of its corpus in
the case of open-ended schemes and upto 10% of its corpus in the case of close-ended schemes.
Apart from raising the resources for venture capital funds this would provide an opportunity to
small investors to participate in venture capital activities through mutual funds.
9. Government of India guidelines: The government of India (MOF) guidelines for overseas
venture capital investment in India dated September 20, 1995 will be repealed by the MOF on
notification of SEBI Venture Capital Fund Regulations.

10. The following will be the salient features of SEBI (Foreign Venture Capital Investors)
Regulations, 2000.

a. Definition of foreign venture capital investor: Any entity incorporated and established outside
India and proposes to make investment in venture capital fund or venture capital undertaking and
registered with SEBI.

b. Eligibility criteria: Entity incorporated and established outside India in the form of investment
company, trust partnership, pension fund, mutual fund, university fund, endowment fund, asset
management company, investment manager, investment management company or other
investment vehicle incorporated outside India would be eligible for seeking registration from
SEBI. SEBI for the purpose of registration shall consider whether the applicant is regulated by an
appropriate foreign regulatory authority; or is an income tax payer; or submits a certificate from
its banker of its or its promoters‘ track record where the applicant is neither a regulated entity not
an income tax payer.

C. Investment criteria:

(a) Disclosure of investment strategy;

(b) Maximum investment in single venture capital undertaking not to exceed 25% of the funds
committed for investment to India. However, it can invest its total fund committed in one venture
capital fund.

(c) At least 75% of the investible funds to be invested in unlisted equity shares or equity linked
instruments.

(d) Not more than 25% of the investible funds may be invested by way of;

(1) Subscription to initial public offer of a venture capital undertaking whose shares are proposed
to be listed subject to lock-in period of one year;

(2) Debt or debt instrument of a venture capital undertaking in which the venture capital fund has
already made an investment by way of equity.

11. Hassle free entry and exit: The foreign venture capital investors proposing to make venture
capital investment under the Regulations would be granted registration by SEBI. SEBI
registered foreign venture capital investors shall be permitted to make investment on an
automatic route within the overall sectoral ceiling of foreign investment under Annexure III of
Statement of Industrial Policy without any approval from FIPB. Further, SEBI registered FVCIs
shall be granted a general permission from the exchange control angle for inflow and outflow of
funds and no prior approval of RBI would be required for pricing, however, there would be ex-
post reporting requirement for the amount transacted.

12. Trading in unlisted equity: The Board also approved the proposal to permit OTCEI to
develop a trading window for unlisted securities where Qualified Institutional Buyers (QIB)
would be permitted to participate.

Consumer Loan / Consumer Credit

The services of banks which facilitate finance for purchasing consumer durables is called
consumer loan or credit or finance. It refers to the raising of finance by individuals for meeting
their personal expenditure or for the acquisition of durable or semi durable goods. It is an
important asset based financial service in India. The objective of consumer finance is to provide
credit easily to the consumer at his door steps. This include credit merchandising deferred
payments, installments, installment buying, hire purchase, payout of income scheme, pay-as-you
earn scheme, easy payment, credit buying, installment credit plan, credit cards etc.

Features of consumer credit

1. Acquisition of durable assets- it is a method of financing for acquiring durable and semi-
durable assets
2. Individual financing- under consumer credit scheme, finance is provided to individual or to
joint individuals.
3. Immediate possession-consumer gets possession of assets immediately when a fraction of
price is paid
4. Payment in installments – under consumer credit scheme assets price is paid through number
of installments.
5. Short or medium term finance- duration of finance normally ranges between 3 months to 5
years.
6. Agreement – when there are only 2 parties to the contract, it is called a bipartite agreement
(customer and dealer cum financier) and where there are three parties, such agreement called
tripartite agreements (the customer, dealer and financier).
7. Multiple structure- structure of financing may by way of hire purchase, conditional sale or
credit sale.
8. Down payment- it involves down payment normally ranging from 20 to 25% of asset price.

Forms / Types of Consumer credit

1. Revolving Credit: it is an ongoing credit arrangement. It is similar to overdraft facility. Here

a credit limit will be sanctioned to the customer and the customer can avail credit to the extent of
that limit. Eg. Credit card.
2. Cash loan: the buyer consumer get ready cash from banks and financial institutions.
3. Secured Credit: in this form, the financier advances money on the security of appropriate
collateral.
4. Unsecured credit: when financier advances fund without any security such adavances called
unsecured credit. But it is allowed only to reputed customers.
5. Fixed credit: in this form, finance is made available to the customers as a term loan for fixed
period say, for one year, for 5 years and so on.
Advantages of Consumer Credit

1. Compulsory saving: it promotes compulsory saving habit among the people. To make
periodical installments knowingly or unknowingly people cut short their other expenses and
save.
2. Convenience: considering nature and types of consumers, credit facility offers schemes to the
convenience of the consumers. Eg. ―Walk in, Drive out‖, ―Pay as you earn‖.
3. Emergencies: Consumer credit is also available to meet personal urgent requirements like
family requirements, festival requirements, marriage requirements etc.
4. Assists to meet target: when the dealer themselves arrange credit facility to the consumers,
more and more customers will be attracted so that sales target can be easily achieved.
5. Assists to make dreams to reality: Consumer credit facilitates an opportunity to possess and
own those dreams on convenient terms.
6. Enhances living standard: consumer credit enhances living standard of the people by
providing latest articles and amenities at reasonable and affordable terms.
7. Accelerates Industrial Investments: increasing demand for consumer durables results into
flow of more investment in related industry.
8. Economies of large scale production: More demand leads to more production which leads to
large scale operation and thus leads to price reduction for consumers.
9. Economic Development and national Importance: above said factors will promotes
employment opportunities, national income, economic balance etc. of a country.

Disadvantages of Consumer Credit

1. Promotes blind buying: facility to purchase at somebody else‘s money tempts people to buy
blindly and unnecessary articles.
2. Leads to Insolvency: blind buying of goods make these people insolvent/ bankrupt within a
short span of time.
3. It is costlier: along with the convenience that it offers it charge the customers for all these
convenience offered. Thus it becomes costlier.
4. Artificial boom: the economic development posed by the impact of consumer credit is not
real but artificial.
5. Bad debt Risk: by whatever name called credit is always have inherent credit risk. Default is
a major threat of consumer credit.
6. Economic Instability: artificial boom and depression leads to economic instability and causes
chaos in economic progress.